Title

The Insurance Hypothesis: An Examination of KPMG's Audit Clients around the Investigation and Settlement of the Tax Shelter Case

Authors

Authors

D. L. Brown; S. Z. Shu; B. S. Soo;G. M. Trompeter

Comments

Authors: contact us about adding a copy of your work at STARS@ucf.edu

Abbreviated Journal Title

Audit.-J. Pract. Theory

Keywords

insurance hypothesis; KPMG; tax shelter; LEGAL LIABILITY; FIRM TENURE; QUALITY; REPUTATION; MARKET; CREDIBILITY; IMPACT; FORECASTS; ACCRUALS; EARNINGS; Business, Finance

Abstract

Although prior literature has suggested that independent audits provide an implicit form of insurance against investor losses (the "insurance hypothesis"), it has been challenging to isolate the "insurance" effect. In this paper, we use a unique setting to examine this effect. In 2002, KPMG was investigated by the U.S. Department of Justice in relation to tax shelters sold by the firm. From then until early 2005, several news reports suggested that KPMG would be indicted and suffer potentially the same fate as Arthur Andersen. However, in August of 2005 KPMG entered into a deferred prosecution agreement with the U.S. Department of Justice, which ended widespread speculation of an impending federal indictment against the accounting firm. Because the investigation centered around tax services offered by the firm, we argue that the circumstances surrounding the investigation and settlement provide a natural setting to test the insurance value provided by auditors. We show that KPMG audit client firms experienced significant negative abnormal market returns when it appeared more likely that KPMG would face criminal charges, but earned significantly positive abnormal returns following news reports of an impending settlement. Further, these abnormal returns appear to be driven by KPMG client firms in greater financial distress or subject to greater litigation risk. These findings are consistent with the insurance hypothesis. Although we cannot completely eliminate other explanations such as an assurance effect or switching costs, we argue that such explanations are unlikely to drive our main findings.

Journal Title

Auditing-a Journal of Practice & Theory

Volume

32

Issue/Number

4

Publication Date

1-1-2013

Document Type

Article

Language

English

First Page

1

Last Page

24

WOS Identifier

WOS:000326346700001

ISSN

0278-0380

Share

COinS